National Society of Compliance Professionals National Membership Meeting October 18-20, 2006 Washington, D.C.

Transcription

1 National Society of Compliance Professionals National Membership Meeting October 18-20, 2006 Washington, D.C. OUTLINE Panel III(a)BD Clearing Arrangements for Introducing Firms Who s Responsible? by: Paul B. Uhlenhop LAWRENCE, KAMIN, SAUNDERS & UHLENHOP, L.L.C. Chicago, Illinois Co-Panelist Bryan D. Pfister, Vice President of Operations NORTHERN TRUST SECURITIES, INC. Chicago, Illinois Lawrence, Kamin, Saunders & Uhlenhop L.L.C. 2006

2 National Society of Compliance Professionals National Membership Meeting October 18-20, 2006 Washington, D.C. INDEX I. Introduction II. Understanding the Arrangement III. Key Functions of the Clearing Arrangement IV. New Developments A. Outsourcing B. Outsourcing of Document Preparation and Storage Under SEC Rules 17a-3 and 17a C. Best Practices Regarding Customer Notification of Service Fees D. AML Correlation Issues E. Introducing Broker Best Execution F. Regulation SHO G. Piggybacking Arrangements V. Introducing Broker-Dealer Capital and Financial Responsibility Requirements, In General A. SEC Rules 15c3-1 and 15c B. SEC Rule 15c3-1 Capital Requirements C. SEC Rule 15c3-3: safeguarding Customer Funds and Securities D. Summary VI. Proprietary Assets Held by Clearing Firm VII. Check Writing and Local Cashiering VIII. Risk Management i

3 IX. Introducing Broker-Dealer Considerations in Negotiating a Clearing Arrangement A. Business Activities B. The Amount of Clearing Deposit C. ACT Credit Line D. Cost of Clearing E. PAIB F. Financial Reports and Financial Information G. Registration H. Customer Accounts I. Acceptance of Accounts and Sales Practice Obligations J. Compliance Procedures and Exception Reports K. Margin and Extension of Credit L. Maintenance of Books, Records and Reports M. Reports by the Introducing Firm to the Clearing Firm N. Customer Funds and Securities O. Local Deposit of Funds and Drafting Authority P. Confirmations and Account Statements Q. Execution of Orders and Transactions R. Commissions and Fees S. Return of Clearing Firm Deposit T. Indemnification U. Exclusive Services V. Proprietary Trading, Underwriting, Market Making and Specialist Activities ii

4 W. Disciplinary Action, Regulatory Forms and Notices X. Use of Clearing Firm s Name Y. Excess SIPC Coverage Z. Termination AA. Non-Solicitation Provisions BB. Arbitration CC. Anti-Money Laundering Provisions X. Negative Consent Letters and Bulk Account Transfers iii

5 NATIONAL SOCIETY OF COMPLIANCE PROFESSIONALS NATIONAL MEMBERSHIP MEETING By: Paul B. Uhlenhop, Esq. 1 Lawrence, Kamin, Saunders & Uhlenhop, L.L.C. Chicago, Illinois CLEARING ARRANGEMENTS FOR INTRODUCING FIRMS WHO S RESPONSIBLE? I. Introduction The purpose of this outline is to discuss key business and regulatory issues that every introducing broker-dealer should consider before entering into a clearing arrangement. There are numerous business as well as regulatory complexities to the clearing arrangement between an introducing broker-dealer and clearing broker-dealer. For a detailed and extensive legal and business discussion of the clearing arrangement, see the definitive legal work describing clearing arrangements of Mr. Henry Minnerop entitled Clearing Arrangements which appears in the Business Lawyer. 2 II. Understanding the Arrangement There are essentially two types of clearing arrangements, the most common is what is called a fully disclosed clearing arrangement. In a fully disclosed clearing arrangement, the introducing broker-dealer introduces transactions to the clearing firm for clearance, settlement and custody. The arrangement is called fully disclosed because division of the functions between the clearing firm and introducing firm is disclosed in a notice to the customers of the introducing firm. The other type of clearing arrangement is an omnibus arrangement. In an omnibus clearing arrangement, an omnibus clearing firm carries in a single account the positions for all of the introduced customer transactions of the introducing firm. Proprietary positions may also be carried. The omnibus clearing firm performs clearance, settlement, execution and custody pursuant to contract with the introducing firm. The proprietary transactions must be in an account separate from customer transactions at the omnibus firm. However, in the omnibus arrangement, the introducing firm remains legally responsible for custody, clearing, capital requirements, reserve deposits, books and records as a clearing firm but the omnibus broker-dealer contractually performs certain of these functions for the introducing firm. In a fully disclosed introducing broker-dealer arrangement, the introducing broker-dealer will generally have significantly less financial responsibility requirements under the SEC capital rule 15c3-1 and under the SEC financial safekeeping rule 15c3-3. Furthermore, although the introducing broker-dealer will be responsible for its required books and records, many of those will be generated and maintained by the clearing firm for the introducing broker-dealer pursuant to the clearing agreement with the introducing broker-dealer. The clearing firm also usually provides excess SIPC insurance. 1 Mr. Uhlenhop is a member of the bars of the states of Illinois and of New York Bus Law 917 (May 2003). 1

6 In an omnibus relationship, the introducing firm has a higher capital requirement, must meet the requirements of the SEC safekeeping of customer funds and securities and must maintain the required books and records. Furthermore, in the omnibus relationship, any excess SIPC insurance would be maintained by the introducing firm. One of the advantages of the omnibus arrangement is that, particularly with respect to securities in which the firm does not effect many transactions, such as foreign securities or certain other types of securities, the introducing firm would not necessarily have to be a member of, for example, foreign clearing organizations or other organizations. Likewise under the omnibus arrangement for United States securities or options, clearance and settlement may sometimes be effected by the omnibus broker-dealer without the introducing firm being a member of a clearing organization such as National Securities Clearing Corporation or the Options Clearing Corporation. The clearing agreement is a classic outsourcing arrangement under which certain functions of the correspondent or introducing broker-dealer are outsourced to the clearing firm. Clearing agreements have to conform with National Association of Securities Dealers, Inc. ( NASD ) Rule 3230 or its counterpart New York Stock Exchange, Inc. ( NYSE ) Rule 342. In addition, the NASD in its recent Notice to Members (July 2005), discusses members responsibility when outsourcing other activities to third-party service providers. Both rules and outsourcing are discussed in separate sections below. Business economics drive the clearing relationship as is explained in more detail below. The fixed cost for clearing, settlement and execution of transactions today is very high because firms that clear transactions must have a large number of electronic systems, memberships in clearing organizations, deposits with clearing organizations and highly experienced personnel in order to effect settlement, clearing and execution of transactions. Start-up cost for a firm to clear all of its transactions is enormous and generally cannot be accomplished economically. In addition, the regulatory approvals and memberships required to establish a clearing relationship for a fully clearing firm clearing all types of securities are almost impossible to effect from a regulatory standpoint for a startup broker-dealer because the regulators will not give the appropriate approvals nor will the memberships and clearing organizations be available unless the firm has a considerable amount of experience, risk control systems and experienced personnel. Until a firm has a very large number of transactions, the fixed cost for clearing per transaction will be far higher than if the firm clears its transactions at an established clearing firm. Because of the enormous fixed cost of systems, capital, personnel and regulatory requirements, clearing firms have a significant advantage if they can attract additional business because the additional transactional business adds very little incremental cost. Consequently, clearing arrangements costs are very competitive. III. Key Functions of the Clearing Arrangement Mr. Minnerop, in his definitive article, identifies key functions involved in the operation of customer accounts and the settlement and clearance of transactions in such accounts as follows: 1. opening, approving, and monitoring customer accounts; 2. providing investment recommendations or accepting customer orders; 3. executing customer orders; 4. extending credit in margin accounts; 2

7 5. providing written confirmations of executed orders to customers; 6. receiving or delivering funds or securities from or to customers; 7. maintaining books and records that reflect transactions, including rendering monthly or periodic statements of account to customers; 8. providing custody of funds and securities in customer accounts; 9. clearing and settling transactions effected in customer accounts; and 10. amending electronic systems for compliance and management of the introducing broker-dealer. 3 If a firm is self-clearing, it will perform all of the above functions that are applicable to its business. If a firm introduces its accounts on a fully disclosed basis, the clearing agreement will divide the above functions between the introducing firm and the clearing firm by contract. Generally in most clearing arrangements, all of the back office operations are handled by the clearing firm and the front office or customer relationships are performed by the introducing firm. In the omnibus relationship, some of the back office and execution functions are performed on a contract basis for the introducing broker-dealer but the introducing firm is responsible for all of those functions as if it was performing them itself. The rules of the NYSE and the NASD require that when an introducing broker-dealer and a clearing broker-dealer enter into a fully disclosed relationship dividing the functions between them, the customer must be notified in a summary statement of the nature of the division of functions and which entity will be performing what function. 4 Most fully disclosed clearing arrangements provide that all customer relation functions are the responsibility of the introducing broker-dealer. Generally, in the fully disclosed arrangement the introducing broker-dealer is responsible for opening, approving and monitoring customer accounts, providing any recommendations, dealing with customer complaints and problems, accepting and executing customer orders, collecting margin and compliance related to these areas. Customer orders may be executed by the introducing firm either through the clearing firm or through some third broker-dealer and given up to the clearing firm for settlement. While credit may be extended by the clearing firm that carries the customer s account to the customer, the margin credit is, under most clearing agreements, the financial responsibility of the introducing firm. The introducing firm must indemnify the clearing firm for any margin or credit losses (i.e., customer s failure to pay). While in most clearing arrangements the confirmations are prepared by the clearing firm and are mailed by it, confirmations may be printed and mailed to customers by the introducing firm. Monthly account statements are usually prepared and mailed by the clearing firm. Under the SEC financial responsibility rules discussed in Section V below, an introducing broker-dealer may receive customer funds or securities for prompt transmittal to the clearing firm but may not hold or carry customer funds or securities without substantially increased capital and other requirements. Some broker-dealers elect the higher capital requirements even though they introduce on a fully disclosed basis. However, this is fairly rare because of the additional capital required and is usually limited to firms engaged in certain proprietary securities activities. 3 Id. at p. 924, fn NYSE Rule 342; NASD Rules of Conduct

8 In most clearing arrangements, the clearing firm agrees not to disclose the details of the customer accounts to affiliates or third parties and not to solicit the customer accounts for its own business during the term of the clearing arrangement and in some cases after the clearing arrangement. Likewise, there are generally provisions against solicitation and hiring of employees of the introducing broker-dealer by the clearing firm without the introducing broker-dealer s consent. For further discussion, see Section IX.AA below. IV. New Developments A. Outsourcing. In July 2005, in NTM 05-48, the NASD called to members attention their responsibilities when outsourcing activities to third-party service providers. In that release, the NASD noted that for many years under NASD Rule 3230 clearing arrangements have been permitted. The release points out that allocation of certain functions and responsibilities, such as execution services, custody, margin, maintenance of books and records, and other activities, are subject to NASD Rule However, NTM states that outsourcing arrangements with entities have grown substantially over the last 10 years. Some of these entities to which functions may be outsourced, such as data service providers, may be unregulated. Under NTM 05-48, the NASD cautions members that in dealing with third-party service providers, the service provider must be a registered broker-dealer if any of the outsourced activities or functions would be required to be the subject of the broker-dealer s supervisory system and written supervisory procedures pursuant to Rule NTM also specifically stated that outsourced activities and functions require registration because the person performing the activity would be an associated person of the member irrespective of whether such person is registered with the member. An exception to this is where the third-party service provider is separately registered as a broker-dealer and contractual arrangement between the member and service provider is contemplated by specific NASD, other SRO rules or other applicable federal securities regulations. An example would be the clearing agreement. Although responsibility for supervisory and compliance activities may not be outsourced, this does not preclude a member from outsourcing certain activities that support the performance of its supervisory and compliance procedures. This would include monitoring reports from the clearing firm, including exception reports which are discussed below. The outsourcing memorandum points out that a member s supervisory system and written supervisory procedures must include procedures regarding outsourced activities to ensure compliance with applicable laws and regulations. Specifically, the procedures should include: 1. Due diligence analysis of all current and prospective third-party service providers to determine their capability to perform the outsource activities. 2. Continuing procedures to oversee, supervise and monitor the service provider s performance of covered activities, designed to assess the service provider s continued fitness and ability to perform the outsourced activities. 3. Access for all appropriate regulators to the service providers work product in the same manner as if it was performed in-house. 4

9 4. Specific policies to determine whether outsourced activities are appropriate, including review of such factors as financial, reputational, and operational impact if the third-party service provider fails to perform, including impact on customers and impact on member s ability to conform with regulatory requirements. B. Outsourcing of Document Preparation and Storage Under SEC Rules 17a-3 and 17a-4 Any outsourcing of records and documents required to be maintained under SEC Rule 17a- 3 and 17a-4 are subject to specific requirements contained in both Rule 17a-3 and 17a-4. SEC Rule 17a-4(f) sets forth the requirements for maintenance of documents in electronic storage media by the broker-dealer or by a third party, including a clearing firm. Rule 17a-4(f), with respect to electronic media, requires that a broker-dealer notify its examining authority 90 days prior to employing an electronic media for records. If a third-party outsource is used to prepare or maintain electronic records, documents or data, the third-party must execute an undertaking required by 17a- 4(f)(3)(vii). Furthermore, 17a-4(i) requires an undertaking with respect to books and records maintained or preserved on behalf of the broker-dealer permitting examination of such books and records by the representatives or designees of the SEC and requires that they be available at any time during business hours. It also requires that the outsource be able to furnish true and correct and current hard copy of any and all books and records. C. Best Practices Regarding Customer Notification of Service Fees The NYSE in Information Memo Number 05-41, June 13, 2005, discusses notification of customers of service fees and service fee changes. While the NASD does not have a similar Notice to Members, the NASD s position is the same as the New York Stock Exchange s position. For Introducing Brokers, these practices are particularly important because they have to be coordinated with the clearing firm and sometimes include the clearing firm s fees. Most clearing fees will work with Introducing Brokers to facilitate notification, sometimes at the cost of the Introducing Broker. The memo sets forth best practices regarding customer notification of service fees as follows: 1. When opening accounts, provide customer with written notification of all Fees that are in effect for the type of account being opened at the time of account opening, or scheduled to take effect within 30 days of account opening. 2. Mail written notification of any increase in Fees, at least 30 days prior to the increase, to the last known address of every customer whose account is subject to such fees. 3. Modes of written notification OTHER THAN traditional letters whose sole purpose is to inform customers of Fee increases, such as statement stuffers (written notices of increased Fees included with account statements), newsletters, or announcements of increased Fees included in the account statements themselves, should contain clear, concise, conspicuously located information about the Fee increases. In other words, notices of Fee increases should be written in plain English, and should not be buried among other text, circulars, or correspondence. 5

10 4. Post all Fees on any internet website maintained for the purpose of communication or interaction with customers. Post all anticipated Fee changes, and the projected date of those changes, to such websites. Promptly update such websites to reflect Fee changes. D. AML Correlation Issues The anti-money laundering program of an introducing broker must take into consideration the resources and the anti-money laundering program of its clearing firm. A smooth integration and understanding as to who is going to do what is critical and has become more critical as AML has risen in importance. Most clearing agreements today have as part of the clearing agreement or as part of an addendum to it detailed provisions setting forth the anti-money laundering obligations of each of the introducing broker and the clearing firm. These provisions generally spell out the introducing broker s responsibility, which is the primary responsibility, but it also provides for cooperation between the clearing firm and the introducing broker. The clearing firm generally agrees to provide certain types of reports to the introducing broker with respect to frequency of transactions and type of transactions. In some cases, particular types of accounts are prohibited or limited, such as non-resident alien accounts. These agreements provide that both parties must comply with an anti-money laundering laws. As far as customer identification, the responsibility in most cases is joint. Consequently, the clearing firm needs to maintain basic documentation with respect to the customer. However, the introducing broker generally has the responsibility to obtain and verify certain of that documentation information. Both the clearing firm and the introducing broker have the opportunity and responsibility to refuse to accept a customer if appropriate under AML policies. Filing of suspicious activity reports is a responsibility of each of the introducing broker and the clearing firm. Each firm is required to submit a report if they have the information even though they know the other party is going to be submitting a report. Generally these agreements provide that when one party obtains information that might warrant a suspicious activity report, the other party will be notified. With respect to sharing information, AML requires that there be a sharing agreement that meets the regulatory requirements to share information. In most cases, the sharing of information is covered in the clearing agreement or the AML addendum. The SEC as well as other federal agencies are increasingly focusing on AML as terrorist activity increases. Consequently, introducing brokers need to focus on new information that is coming out and to be certain that their programs dovetail with that of their clearing firms. Most clearing firms provide a significant amount of AML help to their introducing brokers, but it is generally up to the implementing brokers to implement and carry out the programs with respect to their responsibilities. E. Introducing Broker Best Execution The NASD staff, in connection with examination of introducing brokers, has recently focused on best execution. In many cases, a correspondent broker-dealer may execute all or most transactions for customer retail orders through its clearing firm. Alternatively, it may send its order 6

11 flow to a third-party executing broker-dealer and clear the transactions through the introducing broker s clearing firm. See Section VIII below for a more detailed discussion. A discussion of best execution is a complex issue that is worthy of a full seminar. For that reason, this section focuses only on NASD NTM (April 2001). The best execution obligation of an introducing broker has become much more complex and difficult as a result of electronic trading, automation in the market and the evolution of the trading markets. All broker-dealers have as an agent a duty of loyalty and a duty of due care. The duty of due care requires a broker-dealer as an agent of a customer to exercise care to obtain the most advantageous terms for the customer unless the customer otherwise directs the broker-dealer. Most importantly, NTM requires regular and rigorous review of best execution by all broker-dealers handling retail or institutional orders including introducing broker-dealers. There are also a number of other legal provisions which we will not discuss in this section. For example, Section 28(e) of the Securities Exchange Act of 1934 provides a safe harbor for brokerage and research services in connection with securities transactions provided by a brokerdealer to a money manager that has investment discretion provided the commissions are reasonable in relationship to the services provided. In addition, there are specific disclosure requirements in the federal securities laws and the anti-fraud provisions. 5 As discussed above in Section IV.C., the NASD requires specific disclosure with respect to fees. NASD Rule 2320 deals with best execution and inter-positioning. NASD Rule 2440 deals with fair prices and commissions and IM deals with a mark-up policy. If orders are internalized, special procedures need to be in place to review those transactions to ensure compliance with the many applicable laws and regulations involving internalized executions. Although the obligation of best execution is undisputed, the definition of what is best execution in evolving markets is much less clear. The SEC s view is that the following things should be considered: order size; execution speed; trading characteristics; availability of market information; execution technology; access to various market centers; and the cost and difficulty associated with achieving such success. Many introducing correspondent brokers transmit all of their customer orders to their clearing firm for execution. With the advent of electronic execution systems, some introducing brokers funnel order flow to one or more executing brokers who execute the transactions and give up the transactions for clearing at the introducing broker s clearing firm. See Section VIII. Recognizing these complexities and difficulties, the NASD, in NTM 01-22, provided guidance on best execution compliance. 6 Specifically, NTM requires that NASD broker-dealers, when handling customer orders, conduct regular and rigorous reviews of executions of the market and market makers to which their orders are routed to ensure compliance with their best execution obligations. The introducing broker must make sure its executing broker-dealers are complying with the duty of best execution according to NTM Importantly, the NASD permits a correspondent that routes its order flow to a clearing firm or other executing broker-dealers to rely on the clearing firm or the executing firm s regular and rigorous review as long as the results and 5 See, for example, Securities Act of 1933, 17(a); Securities Exchange Act of 1934, 10(b) and the rules thereunder. 6 See also, NTM (April 2001); see also, NTMs (June 2000), and (Feb. 1999), (Dec. 1998), (Sept. 1997) and (Oct. 1996). 7

12 rationale are fully disclosed to the introducing firm and the introducing firm periodically reviews such data. This requires the introducing broker to analyze the data from its clearing firm and consider the quality of execution of other market centers and other venues where the orders may be executed. Introducing brokers who send order flow to their clearing firm or to third party executing firms need to have supervisory procedures showing their review and analysis of the executions by the executing firms to which they funnel order flow. Furthermore, if there are any payments or consideration for such order flow it must be disclosed to customers. Many small broker-dealers have a committee that meets regularly, at least quarterly, to review the executions that it is receiving. Minutes of such meetings and the underlying data should be preserved. An introducing broker should also be familiar with SEC rules 605, 606 and Rule 605 requires disclosure of certain order execution information by market centers. 8 Rule 606 of NMS requires disclosure of order routing information by clearing firm or executing broker-dealer and if applicable the correspondent must comply with it or if it is routing its orders to another brokerdealer for execution, review the information provided by the executing broker as part of its due diligence obligation. Furthermore, customer account statements under NMS Rule 607 are required to contain certain information concerning order routing practices. In summary, this is a very complex area that introducing brokers must consider and coordinate with firms through which they execute, including its clearing firm if the clearing firm is a primary executing broker-dealer for the correspondent s or customer s orders. F. Regulation SHO Regulation SHO regulating short sales became effective September 7, with a compliance date of January 3, Regulation SHO provides a new regulatory framework for short selling of securities. For an introducing broker and clearing broker, there are several key objectives: (1) the creation of a uniform marking requirement for sales of all equity securities; (2) the establishment of locate and delivery requirements in order to address issues associated with fails-to-deliver; (3) a requirement that when the Threshold of fails of a particular security reaches a defined level, broker-dealers must buy in the securities or have prearranged for delivery prior to a short sale. There also is a new price test for short sales, but it is subject to a one year pilot program. The SEC Division of Market Regulation has Responses to Frequently Asked Questions concerning Regulation SHO on the SEC web site. 10 Rule SHO applies to any transaction that involves the use of jurisdictional means to effect short sales in securities traded in the United States. This means that many international securities are within the scope of the Rule. Rule SHO does not apply to bonds, but it does apply to convertible securities. Short sales do not include short sales in connection with underwritten offer CFR Rule 605 was previously Rule 11Ac-5. 9 SEC Release (July 28, 2004) 69 F.R (August 6, 2004); see also NTM (December 2004)

13 All sales have to be marked long, short or short exempt. A security may be marked long only if the person has a net long position. Securities may be marked SL for long sale SS for short sale and SX for a short sale exempt. Regulation SHO provides an exception for certain short sales such as bona fide market makers, block positioners and in certain other cases. These should be marked short except. Since OTC bulletin board stock short sales are not subject to a price test, such short sales do not have to be marked. The locate and delivery requirement provides a uniform rule requiring a broker-dealer, prior to effecting a short sale in an equity security, to locate securities available for borrowing in order to be able to deliver securities on settlement date. Under SHO, a broker-dealer may not accept a short sale in an equity security if the broker-dealer does not have reasonable grounds to believe that the security can be borrowed so that it can be delivered on settlement date. Reasonableness is determined on the facts and circumstances basis. Broker-dealers are specifically permitted to use easy-to-borrow lists from their clearing firm or other reliable easy-to-borrow lists. If an easy-toborrow list is from a clearing firm through which the introducing broker does not generally clear, it would not be reasonable to rely on the list if there is otherwise a relationship with the clearing firm so that delivery would be made to the broker-dealer s clearing firm. The burden of performing the locate prior to effecting a short sale is on the executing broker. Broker-dealers may rely on assurances from customers that a customer has the security or may obtain assurance from another identified source in time to settle the trade. The source should be identified at the time of execution of the trade. If, however, a customer has given prior assurances of an identified source with a resulting failure to deliver, assurances from the customer or the source would not be considered reasonable absent unusual circumstances. Likewise, reliance on an easy-to-borrow list would not be reasonable if there were fails as a result of using the list. Executing brokers must take steps, either before or after a short sale, to confirm the locate information provided by a customer. If a security becomes a Threshold security based on the number of fails at a national clearing organization, a participant in a registered clearing agency that has fails to the agency for a Threshold security for thirteen consecutive settlement days must, beginning the next business day: (1) immediately take steps to close out the fails-to-deliver; and (2) until the fails-to-deliver position is closed out the participant and any broker-dealer which it clears, must borrow the security that is the subject of the fail in advance of any short sale or enter into bona fide arrangement to borrow such security in advance of the short sale. The most recent Q&A as of March 17, 2006, describes the required methodology under Regulation SHO for clearing firms to apply reductions in fails. If the clearing firm reduces its open fail-to-deliver position prior to the 13 th consecutive settlement day and such reduction is reflected at NSCC, the participant may apply the reduction to the most recent increase in its fail-to-deliver position reflected at NSCC and then to any increase in its fail position that existed at NSCC on the date preceding that day and so forth until the entire amount of the reduction has been applied. This is a required methodology. In determining the close out requirement, the participant must look to fail positions that NSCC and not fails at the customer level. Unfortunately, there is a disconnect for clearing firms and correspondent brokers. The clearing firm may have net fails to NSCC but its correspondent s customers may not have fails to the clearing firm or customers may be long as a result of particular types of transactions but securities have not been delivered into the clearing firm to enable it to close the fail at NSCC. In such cases, the clearing firm may be required to buy 9

14 in the position. Whether the buy in is to be assigned to a correspondent firm customer or whether the clearing firm assigns the buy in to its error account is a troubling question because the clearing firm that assigns it to its error account is unable to close the position without creating a new short until the securities are delivered to it that are causing the fail, thus putting the market risk on the clearing firm in its error account. The NASD, effective July 3, 2006, adopted a short sale delivery requirement similar to those in Regulation S-H for non-reporting OTC equity securities. 11 Rule 3210 requires clearing agency participants to close out all failures in non-reporting threshold securities that have existed for 13 consecutive settlement dates. A non-reporting security is an equity security of a company that is not reporting under Section 12 of the 34 Act and for five consecutive days has (1) aggregate fails-to-deliver at the registered clearing agency of 10,000 shares or more and (2) a reported last sale during normal market hours for the security on that settlement date that would aggregate to a fail-to-deliver position of position of 50,000 or more. G. Piggybacking Arrangements The SEC recently issues a letter to the New York Stock Exchange concerning piggybacking arrangements. 12 Failure to follow the specific requirements of the no-action letter would result in clearing deposits or other proprietary deposits being non-allowable assets. The conditions as set forth in the letter are described below. Piggybacking generally involves two introducing firms and one carrying firm and one clearing firm. One introducing firm introduces to the other which introduces all accounts to the clearing firm. The initial introducing firm s clearing deposits are deemed allowable assets for net capital only if certain conditions are met: 1. Option 1: The intermediary introducing firm designates the cash or securities representing the clearing firm s deposit of introducer 1 to be placed in a separate account at the clearing firm in the name of introducer 2 f/b/o introducer Option 2: Introducer 2 can send a notification to the clearing firm advising the firm that the cash and securities representing the deposits of introducer 1 have been placed into the deposit account of introducer If option 1 or option 2 is not done, the intermediary introducing firm must do its own PAIB computation and include the deposit of introducer Additional requirements: a. The carrying and clearing firm sends the PAIB agreement to introducer 2 who must in turn send the agreement to introducer 1 if introducer 1 has complied with either of the above options. 11 NTM (June 2006). 12 New York Stock Exchange Capital Guide, SEC staff to NYSE, No. 00-6, September 2000 Piggybacking Arrangements. 10

15 b. The intermediary must also send a letter to the first introducing firm advising the introducing firm that its deposits are being sent to the carrying and clearing firm which is including them in its PAIB calculation. V. Introducing Broker-Dealer Capital and Financial Responsibility Requirements, in General A. SEC Rules 15c3-1 and 15c3-3 The two key financial responsibility rules are SEC Rule 15c3-1, the net capital rule, and SEC Rule 15c3-3, the rule regulating safeguarding customer funds and securities. Although both rules are fairly complex, a basic understanding of the choices presented under the rules is important for an introducing broker-dealer in connection with understanding its business options and financial requirements of a clearing arrangement. The discussion below is designed to give a general overview of the rules without discussing all of their complexities. Also of importance is SEC Rule 17a-11 which sets a number of minimum thresholds called early warning thresholds. Rule 17a-11 requires prompt notice to the regulators (1) if the brokerdealer s aggregate indebtedness is in excess of 1200% of net capital, or, (2) if the broker-dealer is operating under the alternative standard and its net capital is less than 5% of the aggregate debit items in the reserve formula, or, (3) if the broker-dealer s total net capital is below 120% of the required minimum, or, (4) if the broker-dealer fails to maintain current books or records, or, (5) if the broker-dealer is notified of a material inadequacy by its independent public accountants. In any such event, notice must be given to the SEC and the firm s designated examining authority and various other regulatory organizations with which the firm may be involved. The discussion of the SEC capital rule 15c3-1 below sets forth the minimum net capital requirements for various types of broker-dealers. However, from a practical standpoint, the minimum thresholds of Rule 17a-11 are the true applicable minimum capital level because if the broker-dealer does not meet those thresholds for any but a short period, the self-regulatory organizations or the SEC generally will require the firm to contract its business or cease operations. The SEC capital rule provides a number of alternatives to a broker-dealer. A broker-dealer that wishes to engage in securities activities without restriction and self-clear its transactions has a significantly higher capital requirement. As explained below, firms that engage in more limited activity subject to certain restrictions have a lesser capital requirement. There are a number of different types of clearing arrangements offering a choice of capital requirements to the introducing broker-dealer. B. SEC Rule 15c3-1 Capital Requirements 1. Top Tier Firms That Do Not Have Restrictions on Type of Activity The SEC capital rule provides alternative minimum requirements for a broker-dealer that engages in general securities activity without restrictions. Under either of the two alternatives, 11

16 a broker-dealer must have $250,000 minimum capital. 13 In addition, under one alternative, the broker-dealer must also maintain an aggregate indebtedness ratio not to exceed 1500% of its net capital (or 800% of its net capital for its first 12 months of business). Under the other alternative standard, the broker-dealer is not subject to the aggregate indebtedness standard, but must maintain minimum net capital of not less than the greater of $250,000 or 2% of the aggregate debit items as computed under the SEC Rule 15c3-3 reserve formula. Furthermore, there are additional conditions to the second alternative such as making the Rule 15c3-3 computation on a regular basis, certain deductions and other provisions. 2. The Two Most Common Capital Rule Minimum Requirements Used by Introducing Broker-Dealers a. Broker-Dealers that Introduce Customer Accounts and Receive But Do Not Hold Customer Funds and Securities A broker-dealer must maintain a minimum of $50,000 if it introduces customers on a fully disclosed basis to another broker-dealer that carries the accounts. 14 Under this provision, a broker-dealer may receive but not hold customer or other broker-dealer funds or securities. Under this provision, a broker-dealer may be a member of a selling group but may not be a member of an underwriting group purchasing securities in a fixed underwriting. Most introducing broker-dealers elect to operate under this section. b. $5,000 Broker-Dealers Under this category, a broker-dealer may only engage in agency transactions or riskless principal transactions as defined in the rule. 15 A $5,000 broker-dealer may not engage in the activities described in Sections B.1 and 2(a) above and Sections B.3(a), (b), (c) and (d) below. It may not receive, directly or indirectly, or hold funds or securities for customers or carry any customer accounts or owe money or securities to customers. 3. Other Options and Provisions for Certain Activities a. Broker-Dealers That Do Not Carry Customer Funds or Securities and Engage in Limited Activity of Mutual Funds, Variable Annuities and Savings and Loan Accounts Broker-dealers that do not carry customer funds or securities and promptly transmit them to a clearing firm and are exempt under SEC Rule 15c3-3(k)(2)(i), generally have a $100,000 minimum net capital requirement. 16 See Section IV.C.2 below for a description of SEC Rule 15c3-3(k)(2)(i). Under this exemption, a broker-dealer that carries no margin accounts, promptly transmits all customer funds and delivers all securities received in connection with its activities as a broker-dealer, does not otherwise hold funds or securities for or owe money or 13 SEC Rule 15c3-1(a)(1) & (2)(i). 14 SEC Rule 15c3-1(a)(2)(iv). 15 SEC Rule 15c3-1(a)(2)(vi). 16 SEC Rule 15c3-1(k)(2)(ii). 12

17 securities to customers and effects all financial transactions between the broker-dealer and his customer through one or more bank accounts entitled Special Account for the Exclusive Benefit of Customers of will qualify. b. Dealers Rule Dealers of securities have a minimum net capital requirement of not less than $100, Included within dealers are broker-dealers that are engaged in options otherwise than on a registered national securities exchange or NASDAQ and any broker-dealer that effects more than ten proprietary transactions for its own investment account. Dealers do not include market makers. See Section IV.B.3(d) below. With respect to ten proprietary transactions, there are exceptions for transactions under Rule 15c3-1(a)(2)(v), (a)(2)(vi) or (a)(8). Rule 15c3-1(a)(2)(v) permits principal and agency transactions in variable annuities and mutual funds and transactions to sell securities for immediate reinvestment in mutual funds or variable annuities provided the broker-dealer promptly transmits all funds and delivers all securities received and does not hold funds or securities for or owe money or securities to customers. Rule 15c3-1(a)(2)(vi) provides an exception for broker-dealers that do not hold funds or securities for or owe funds or securities to customers nor carry accounts of customers that engage in riskless principal transactions cleared through another broker-dealer. Rule 15c3-1(a)(8) deals with a specific exception for municipal securities brokers broker that is beyond the scope of this outline. The dealer rule also limits the broker-dealer from engaging in firm commitment underwriting activities but permits the broker-dealer to engage in best efforts or agency or all-or-none underwritings in accordance with paragraph (b)(2) of Rule 15c2-4, so long as the broker-dealer engages in no other dealer activities. c. Mutual Funds and Variable Annuity Dealers and Agents A broker-dealer is required to maintain $25,000 net capital if it acts as a broker or dealer with respect to mutual funds or variable annuities. 18 All funds and securities must be promptly transmitted and the broker-dealer may not hold customer funds or securities or owe money or funds to customers. d. Market Makers, Specialists and Floor Brokers An over-the-counter market maker generally has to maintain net capital of $2,500 for each security in which it makes market up to $1,000, There are additional exemptions for exchange market makers, specialists and floor brokers that do not deal with customers contained in the capital rule which are beyond this discussion SEC Rule 15c3-1(a)(2)(iii). 18 SEC Rule 15c3-1(a)(2)(v). 19 SEC Rule 15c3-1(a)(4). 20 SEC Rule 15c3-1(a)(6) & 15c3-1(b). 13

18 e. Municipal Brokers and Dealers There are special requirements for certain municipal securities brokers who act as brokers broker. 21 f. Broker-Dealers Engaging in Repo Transactions transactions. 22 There are special provisions for broker-dealers that engage in repo C. SEC Rule 15c3-3: Safeguarding Customer Funds and Securities Rule 15c3-3 regulates broker-dealer custody of customer funds and securities. Subsection (k) of the rule provides exemptions that are applicable in many cases to introducing broker-dealers if they do not carry or receive customer funds or securities. In most clearing relationships, the introducing broker-dealer attempts to operate under one of the exemptions of subsection (k) of Rule 15c3-3 which are described below. 1. Mutual Fund Variable Annuity Exemption Subsection (k)(1)(i) provides an exemption provided that the broker-dealer s transactions are limited to (1) the purchase and sale of mutual funds or variable annuity products, either as principal or agent or, (2) agency transactions involving solicitation of accounts for insured savings and loan institution or, (3) the sale of securities for customer for immediate reinvestment in mutual funds. Customer funds and securities received must be promptly transmitted and may not be held by the introducing broker-dealer. The introducing broker-dealer must not owe money or securities to customers. There is also an exemption in (k)(1) for insurance companies that are engaged in certain activities not applicable to the discussion. 2. Special Account Introducing Broker-Dealers Under subsection (k)(2)(i) of Rule 15c3-3, a broker-dealer is exempt if that introducing firm (1) does not carry margin accounts, (2) promptly transmits all funds and securities received, (3) does not hold customer funds or securities, (4) does not owe money or securities to customers, and (5) effects all transactions between the broker-dealer and its customers through one or more bank accounts which are designated as a special account for exclusive benefit of customers of the broker-dealer. Some introducing firms rely on this exemption. 3. Introducing Broker-Dealers Under subsection (k)(2)(ii), an introducing broker-dealer is exempt if it clears all transactions on a fully disclosed basis and promptly transmits all customer funds and securities to the clearing broker-dealer. The clearing broker-dealer must carry all accounts of customers and 21 SEC Rule 15c3-1(a)(8). 22 SEC Rule 15c3-1(a)(9). 14

19 maintain required books under Rules 17a-3 and 17a-4 normally kept by a clearing broker-dealer. Most introducing firms rely on this exemption. D. Summary As can be seen under the above rules, a fully disclosed clearing arrangement provides significant benefits to an introducing broker-dealer depending upon the type of activities in which the broker-dealer is engaged. If the introducing broker-dealer limits its activities as described under various of the sections above, it will have significant less financial responsibility requirements. VI. Proprietary Assets Held by Clearing Firm Proprietary assets of an introducing broker-dealer maintained at a clearing firm are good assets for purposes of computing net capital under Rule 15c3-1 only if the introducing brokerdealer and the clearing firm comply with the SEC interpretation regarding treatment of proprietary accounts of introducing broker-dealers (PAIB accounts). 23 If assets are not held in a PAIB account and pursuant to the provisions of the SEC interpretation, the assets held at the clearing firm by an introducing broker-dealer are considered to be not readily convertible into cash and have no value for capital purposes. Consequently, introducing firms hold assets at clearing firms pursuant to PAIB agreements which include notification to the introducing firm s clearing firm. The PAIB regime does not apply to certain assets held offshore. 24 Because of these PAIB requirements, it is important in any clearing arrangement that an introducing broker-dealer be certain that there is a PAIB agreement with the clearing broker-dealer, that it is properly executed and that proper notices are given. VII. Check Writing and Local Cashiering As discussed above, receipt, delivery and custody of securities of customers generally are the functions of the clearing firm for a variety of reasons, including exemptions in whole or in part from the SEC net capital rule or SEC Rule 15c3-3. However, under tightly controlled conditions, interpretations permit the local deposit of funds to an account in the name of the clearing firm and/or local check drafting by the introducing firm against a local account of the clearing firm. Local cashiering is local deposit of funds to the account of the clearing firm. This works to the advantage of both the clearing firm and the introducing firm. If the introducing firm is a $50,000 broker-dealer, it may receive customers funds as long as it does not hold them. Using this provision, customer checks may be received by an introducing firm and promptly deposited by it into a local bank account that s held in the name of the clearing firm. 23 Letter to Michael Macchiaroli, Associate Director Securities and Exchange Commission, to Messrs. Raymond J. Hennessey, New York Stock Exchange, Mr. Thomas Casella, NASD Regulation, Inc., November 3, 1998; NASD Notice to Members NASD Notice to Members